Now that's good thinking

How to Solve a Banking Crisis

If this blog was in existence during the 2008 financial crisis my disgust for enormous, too big to fail banks would be well documented by now. I might as well give you a flavor of that disgust here and now.

Below is an interesting interview with Iceland’s President Olafur Ragnar Grimsson on their approach to solving a banking crisis. Hint: it does NOT involve tax payer bailouts.

“These were private companies operating fundamentally like private companies, rewarding the bankers and the shareholders, so why when they fail should ordinary people, taxpayers, teachers, nurses, workers, pay the price and bear the burden?”

Why, oh why, is this approach isolated to Iceland?

There are in fact mechanisms in place (and have been for some time) to deal with banking crises. They involve the FDIC stepping in and taking the bank into receivership – during that time failing institutions can be restructured without any loss to depositors or counter parties. What the bail outs really amounted to was bailing out the bond holders of the banks (the investors that lent the banks money so they could leverage their bets 30:1 (i.e. for every dollar that the bank put in they borrowed $30).

Jon Hussman lays this out beautifully here. To use Hussman’s example to illustrate the point:

“Look at Bank of America’s balance sheet, for example. Reported assets are $2.261 trillion. Against that, liabilities to depositors amount to less than half that, at $1.038 trillion. Add in $239 billion for securities that they are obligated to repurchase, $129 billion in trading account and derivative liabilities, and $155 billion for accrued expenses. Now you’ve covered counterparties, as well as vendors or others who might have invoices outstanding. Even then, and you’re still only up to $1.561 trillion of the liabilities. The remaining 31% of Bank of America’s liabilities represent obligations to its own bondholders and equity of its own shareholders. This is well beyond what is sufficient to buffer any loss that the company might take on its assets, while still leaving customers and counterparties completely whole. To say that Bank of America can’t be allowed to “fail” is really simply to say that Bank of America’s bondholders can’t be allowed to experience a loss.”

This is very much an abbreviated solution to a banking crisis but hopefully you get the idea.